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Fanto on Some Preliminary Lessons from the Madoff Scandal, with Supplemental Content

Bernard Madoff used a Ponzi scheme to swindle the very wealthy, and particularly, rich foreigners, including some foreign aristocrats. Like other financial institutions and professionals, Madoff offered investors an illusory product and was unsatisfied with providing necessary, but mundane, securities services. In this Commentary, Professor James Fanto argues that in some respects, Madoff is an appropriate face of the financial crisis, rather than its sideshow. Professor Fanto also argues that the Securities and Exchange Commission’s (SEC) approach towards Madoff preceding the scandal was similar to its respectful attitude towards many of the financial firms at the center of the financial crisis. He writes:

It may be something of a stretch, and even insulting, to liken the financial institutions that have been at the center of the crisis and their professionals to Madoff. But the analogy is not entirely far-fetched. After all, what of value was being sold when mortgage and investment bankers originated subprime and balloon mortgages and then packaged them into vehicles that issued elaborately designed tranches of securities, which themselves were pooled with other similar securities and became the backing for other issuances? To take another example, one could ask what protection were firms like American International Group actually providing when they sold credit default swaps on the mortgage-backed securities. Obviously in these cases, there was no mastermind, like Madoff, orchestrating a fraudulent scheme; rather, the subprime mortgage scandal has complex causes and involved government and private sector actors too numerous to name. Yet huge amounts of investor money vanished in highly questionable investments, much of it into the pockets of the facilitators of the schemes, such as the mortgage originators, commercial and investment bankers, investment advisers who put their funds money into the investments, and the rating agencies.

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The Madoff scandal, as in Enron and Worldcom not so long ago, can be blamed upon identifiable individuals. This contrasts with the financial meltdown where it is hard to find a particular person or persons to blame, although Robert Rubin of Citigroup, Stanley ONeal of Merrill Lynch, and Angelo Mozillo of Countrywide might fit the bill. Blame also has to reach those who should have detected the Ponzi scheme, in this case the SEC. The SEC’s Chair, Christopher Cox, has already publicly expressed his concern over the agency’s failure to detect the fraud. It has also emerged that a former SEC staff member who had been assigned to one of the examinations of Madoff’s firm subsequently married Madoff’s niece, who was herself a compliance officer in the broker-dealer.

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It is premature to draw all the lessons from the Madoff scandal, since the full facts about it have not emerged. However, it is surely an object lesson for investors, even wealthy investors, although people seem to have a hard time learning it. The lesson is that individuals should be careful when making investment decisions on the basis of the social status and reputation of an investment manager or other financial professional. Of course, unless we are investment professionals ourselves, we do not have the time or expertise to evaluate possible investments. In investing as in so many other things, we rely upon the signals sent by status and reputation to help us make our decisions. Why else do investment firms spend so much time and money advertising and maintaining their reputation? Yet it is necessary not to rely unquestioningly upon finance professionals, which means that an investor (or investor representative) must know the basics of his or her portfolio, ask questions about it, and replace a professional who refuses to respond to them. Indeed, a red flag that an investor should never ignore is an investment manager who refuses to release information or to discuss matters with investors, as Madoff reportedly did.